This expectation does not change even when the economy turns down and earnings decline; dividend growth investors still require annual dividend growth. The companies that are able to accomplish this are those with a operating model that generates strong free cash flows with room to pay out a higher percentage as dividends. Below are several companies with a low free cash flow payout (below 40%):

An interesting twist to the above is a 2006 study conducted by Credit Suisse that found high dividend yield stocks generally
outperformed those with lower yields. However, the best returns did not come from those with the highest yields, but those with higher yields coupled with low payout ratios. The study found that high yield, low payout stocks that produced the better returns were priced at low ratios of price-to-earnings, and as a corollary, at high ratios of earnings-to-price; i.e., earnings yield. Put another way, the stocks prices were depressed, thus creating the higher yield and a value play. Below are several dividend growth stocks with a higher yields (around 4%+) and low free cash flow payouts (50% and below):

At some point we will all want to retire, but that is not to say we want our portfolio to stop working for us. A good dividend growth stock portfolio will not only provide us income in our retirement, but provide us more income each year than the one before.

Full Disclosure: Long GD, MDT, ADP, PG, INTC, ABT, GPC, TEG, CINF, LLY, HGIC. See a list of all my income holdings here.

Related Posts
- Rev-up Your Portfolio With Asset Allocation
- The 2010 Elite Dividend Stocks List
- In Dividend Investing, Cash Is King
- 10 Stocks With Sustainable Dividend Growth
- 7 Dividend Stocks To Slay The Wall Street Giants

(Photo Credit)

Below are several companies giving their shareholders a reason not to sell by increasing their cash dividends:

Enterprise Products Partners (EPD) is an integrated provider of natural gas and natural gas liquids services, including processing, fractionation, storage, transportation, and terminalling. April 13th the partnership increased its quarterly distribution to $0.5675/unit. The quarterly distribution will be paid on Thursday, May 6, 2010, to unit holders of record as of the close of business on Friday, April 30, 2010. The ex-dividend date is April 28. The yield based on the new payout is 6.36%.

Genesis Energy (GEL) is a limited partnership focused on the midstream segment of the oil and gas industry in the Gulf Coast region of the United States. April 14th the partnership raised its quarterly distribution 8.9% over the first quarter 2009 to $0.3675/unit. The distribution will be paid on May 14, 2010, to Common Unitholders of record at the close of business on May 4, 2010. The ex-dividend date is April 30, 2010. The yield based on the new payout is 7.20%.

HB Fuller (FUL) is an international manufacturer of adhesives, sealants, paints and specialty construction products. April 15th the company increased its quarterly dividend 2.9% to $0.07/share. FUL is a Dividend Achiever and has raised its dividend for 41 consecutive years. The yield based on the new payout is 1.17%.

Donegal (DGICA) offers personal and commercial lines of insurance to businesses and individuals in 18 Mid-Atlantic, Midwestern and Southeastern states. April 15th the company raised its quarterly dividend 2.2% to $0.115/share. The dividend is payable May 17, 2010 to stockholders of record as of the close of business on May 3, 2010. The yield based on the new payout is 3.08%.

In addition to the above dividend raisers, the following Dividend Aristocrats declared regular quarterly cash dividends:

April 12th Walgreens (WAG) declared a quarterly dividend of $0.1375/share with a 1.5% yield. The dividend is payable June 12, 2010, to shareholders of record May 20, 2010. The ex-dividend date is May 6, 2010. [Analysis]

Pitney Bowes (PBI) on April 12 declared a quarterly dividend of $0.365/share with a 5.9% yield. The dividend is payable June 12, 2010, to shareholders of record on May 14, 2010. The ex-dividend date is May 12, 2010.

April 15th Consolidated Edison, Inc. (ED) declared a quarterly dividend of $0.595/share with a 5.3% yield. The dividend is payable June 15, 2010, to stockholders of record as of May 12, 2010. The ex-dividend date is May 10, 2010.

If you invest in good solid stocks that increase their dividends on a consistent basis, day-to-day share movements will not concern you. For a list of stocks with a long string of consecutive cash dividend increases, see this list.

Full Disclosure: Long ED. See a list of all my income holdings here.

(Photo Credit)

Dividend payout is expressed as a percentage and is calculated by dividing annual dividend per share by annual earnings per share (EPS). This tells the investor what percentage of earning the company is paying out as a dividend. At first blush this may seem to make a lot of sense, but it suffers from the following potential problems:

I. Earnings Does Not Equal Cash

As an accountant, I can tell you our profession in its pursuit of theoretical perfection has adulterated the financial statements to the point that it has become very difficult for non-accountants to understand what’s behind the numbers.  Accounting pronouncements such as SFAS No. 143 “Accounting for Asset Retirement Obligations” (ARO) that requires a company to recognize expenses today for cash payments that may not occur for decades or even centuries widens the gap between earnings and cash. Applying “fair value” principles allowed under GAAP, financial institutions (and others) can mark to market debt on their books and create non-cash income or expense, depending on the direction of interest rates. Many point to mark to market accounting as one of the major contributors to the 2008 financial melt-down.

II. Quality of Earnings

Would you rather a company that you are invested in to increase its earnings by 1.) increasing sales and holding cost down or 2.) sell a fully depreciated plant. Obviously, you would rather have the former since it has the possibility of being duplicated over and over again. You can only sell a specific asset once. In addition to cash and non-cash earnings, a statement of earnings also contains operating and non-operating earnings.

A Better Dividend Payout Calculation

A dividend payout ratio is supposed to provide the investor with an indication of how much cash as a percent of earnings the company is paying its investors. As you can see from the above discussion, a payout ratio based on GAAP net earnings could potentially have a lot of noise in it and not provide a clear picture of the economic condition of the business.

What the investor is really wanting to know is what percentage of cash is the company paying as a percentage of cash generated from running the business. The irony here is that operating cash is readily available on the Statement Of Cash Flows in the Operating section. This section focuses on the cash generated by running the business. It excludes cash generated by selling pieces of the business – these are shown in the investing section. It also excludes cash generated from selling stock or issuing debt – these are shown in the financing section.

In calculating a payout ratio, I prefer Free Cash Flow over Operating Cash Flow. Free Cash Flow is Operating Cash Flow less normal capital expenditures (normally the first line in the investing section). For a business to remain viable, it must replace capital assets when they wear out.

The formula for Free Cash Flow Payout is simply Annual Dividend Per Share divided by Free Cash Flow Per Share. I like to see a percentage of 70% or less. The 70% is somewhat higher than many people look for with a traditional payout ratio. I am comfortable with the higher number since we are talking about real cash generated from running the business vs. accounting earnings that may or may not be there. So how do the two ratios compare?

Needless to say, the variances are all over the place. In many companies I looked at the traditional dividend payout ratio was within 10 percentage points higher than a free cash flow payout. This means the GAAP earnings was lower than the calculated Free Cash Flow. Here are some example of this situation:

• Chubb Corp (CB) – Traditional: 28% – FCF Payout: 21% – Analysis
• Clorox Company (CLX) – Traditional: 50% – FCF Payout: 50%
• Emerson Electric Co. (EMR) – Traditional: 53% – FCF Payout: 45% – Analysis
• Family Dollar Stores Inc. (FDO) – Traditional: 25% – FCF Payout: 22%
• Hormel Foods Corp. (HRL) – Traditional: 34% – FCF Payout: 33%
• International Business Machines (IBM) – Traditional: 23% – FCF Payout: 18%
• 3M Co. (MMM) – Traditional: 50% – FCF Payout: 45% – Analysis
• Microsoft Corp. (MSFT) – Traditional: 32% – FCF Payout: 29%
• SYSCO Corporation (SYY) – Traditional: 52% – FCF Payout: 48% – Analysis
• United Technologies Corp. (UTX) – Traditional: 35% – FCF Payout: 30% – Analysis

Sometime the gap is much larger. This could have resulted from significant non-cash charges on the income statement.  Companies with large gaps include:

• Aflac Incorporated (AFL) – Traditional: 44% – FCF Payout: 10% – Analysis
• CenturyLink Inc. (CTL) – Traditional: 87% – FCF Payout: 46%
• Diebold Inc (DBD) – Traditional: 74% – FCF Payout: 30%
• Illinois ToolWorks Inc. (ITW) – Traditional: 76% – FCF Payout: 31% – Analysis
• Leggett & Platt Inc. (LEG) – Traditional: 262% – FCF Payout: 34% – Analysis
• Nucor Corporation (NUE) – Traditional: 88% – FCF Payout: 29% – Analysis
• Pitney Bowes Inc. (PBI) – Traditional: 73% – FCF Payout: 38%
• PPG Inds Inc (PPG) – Traditional: 158% – FCF Payout: 48%
• RLI Corp (RLI) – Traditional: 158% – FCF Payout: 48% – Analysis
• RPM International Inc (RPM) – Traditional: 84% – FCF Payout: 49% – Analysis
• AT&T Inc. (T) – Traditional: 81% – FCF Payout: 49%

Sometimes the gap is not only large, but goes the other way. This is potentially the most dangerous since focusing on the traditional dividend payout may lead you to believe the dividend is covered better than it actually is. Examples of this situation would include:

• Air Products and Chemicals Inc. (APD) – Traditional: 56% – FCF Payout: 172%
• Franklin Resources Inc. (BEN) – Traditional: 23% – FCF Payout: 48%
• BP Plc (BP) – Traditional: 50% – FCF Payout: 114% – Analysis
• Lowe’s Companies, Inc. (LOW) – Traditional: 27% – FCF Payout: 57% – Analysis
• Exxon Mobil Corp (XOM) – Traditional: 27% – FCF Payout: 54%

Although Free Cash Flow Payout is a better payout ratio than the traditional dividend ratio, the investor should look at both and understand the differences. Taking an expense for impairing goodwill is much different than recognizing an expense for losing a lawsuit. The former will not directly involve cash out the door, but the latter will if the company loses on appeal.

Full Disclosure: Long CLX, EMR, MMM, SYY, UTX, AFL, CTL, ITW, NUE, BP. See a list of all my income holdings here.

(Photo Credit)

High-yield investing often carries a greater degree of risk than I am willing to accept. Recently, a reader alerted me to an article describing a 20-year study by the Schwab Center for Financial Research demonstrates that investments with the highest yields don’t necessarily provide the highest returns and offers a safer way to implement a high-yield approach. Here are some key excerpts from the article:

• Stocks with the highest dividend yield haven’t provided the best total return.
• Research found the highest-yielding stocks had twice as many dividend cuts as the other dividend-paying groups.
• Price momentum is a stock indicator based on the idea that stocks that have been outperforming in the past will continue to do so.
• A simple screen using the six-month price momentum strategy applied to the highest-yielding stocks can help you pick the best performers.
• The screen is implemented using:
  • Stocks in the S&P 500, 400 and 600 indexes.
  • Dividend Yield and click the dividend yields greater than 1.5 times the S&P 500 yield.
  • Capture analyst ratings.
  • 6 Months Price Performance > Price Change.
  • Sort by price performance and select the highest analyst ranked  stocks within the top 45.

Since the article was very Schwab specific, I tried to generalize the above screen. If you have a Schwab account, please refer to the article for more specific instructions.

So, what does all this mean? If you are an income investor that enjoys trading instead of buy and hold, then this may be something you want to explore further.  However, the 11.5% earned with this strategy vrs. the  10.73% for dividend stocks not in the highest yielding group hardly seems worth the effort.

For me, I will continue to focus on high-quality dividend stocks at lower, but growing,  yields. However, for those looking to bump their yield a little, below are several Dividend Aristocrats and Achievers that are currently yielding more than 5%:

CenturyLink Inc. (CTL) – Aristocrat – Yield: 8.6%
Lilly Eli & Co. (LLY) – Aristocrat – Analysis -Yield: 6.0%
Integrys Energy Group Inc. (TEG) – Aristocrat – Yield: 7.8%
Consolidated Edison Inc. (ED) – Aristocrat – Yield: 5.8%
Progress Energy Inc. (PGN) – Achiever – Analysis – Yield: 6.5%
Realty Income Corp (O) – Achiever – Yield: 7.1%
Health Care Property Investors, Inc. (HCP) – Achiever – Yield: 6.8%
Cincinnati Financial Corp. (CINF) – Aristocrat – Yield: 6.2%
Leggett & Platt Inc. (LEG) – Aristocrat – Analysis – Yield: 5.7%
Pitney Bowes Inc. (PBI) – Aristocrat – Yield: 6.0%
AT&T Inc. (T) – Achiever – Yield: 6.2%
Black Hills Corp. (BKH) – Achiever – Yield: 5.8%
Capital City Bank Group (CCBG) – Achiever – Yield: 5.6%
Universal Health Realty Income Trust (UHT) – Achiever – Yield: 7.5%

This by no means is an endorsement of the above stocks. If you are looking for high-yields, you might lower your risk some by looking at a pool of stocks that have a long history of increasing their dividends.

Full Disclosure: Long CTL, LLY, TEG, ED, PGN, O, HCP . See a list of all my income holdings here.

(Photo: Steve Woods)

Company Description: Pitney Bowes Inc. is the world’s largest maker of mailing systems, also provides production and document management equipment and facilities management services.

Fair Value: I consider four calculations of fair value, see page 2 of the linked PDF for a detailed description:

1. Avg. High Yield Price
2. 20-Year DCF Price
3. Avg. P/E Price
4. Graham Number

PBI is trading at a discount to only 1.) above. Since PBI’s tangible book value is not meaningful, a Graham number can not be calculated. If I exclude the high and low valuations and average the remaining two, PBI is trading at a 73.2% premium. PBI had a Star deducted for trading at a premium in excess of 5%.

Dividend Analytical Data: In this section I consider five factors, see page 2 of the linked PDF for a detailed description:

1. Rolling 4-yr Div. > 15%
2. Dividend Growth Rate
3. Years of Div. Growth
4. 1-Yr. > 5-Yr Growth
5. Payout 15% of avg.

PBI earned two Stars in this section for 3.) and 4.) above. PBI has paid a cash dividend to shareholders every year since 1934 and has increased its dividend payments for 26 consecutive years. It’s one year dividend growth rate exceeded its 5-year growth rate. This could indicate the growth rate is accelerating. Last year’s dividend payout was 81%, up from 51% in 2006. Since the increase was in excess of 15 points, a Star is deducted, leaving a net of one Star in this section.

Dividend Income vs. MMA: Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a much less risky money market account (MMA)? This section compares the earning ability of this stock with a high yield MMA. Two items are considered in this section, see page 2 of the linked PDF for a detailed description:

1. NPV MMA Diff.
2. Years to >MMA

PBI earned no Stars in this section, and had one Star deducted for a negative NPV MMA Diff. The negative NPV MMA Diff. means that on a NPV basis for every $1,000 invested in PBI you would earn $33 less than a MMA earning a 20-year average rate of 4.61%. If PBI grows its dividend at 2.7% per year, it will never equal the cumulative earnings from a MMA yielding an estimated 20-year average rate of 4.61%.

Other: PBI is a member of the S&P 500, a Dividend Aristocrat and a member of the Broad Dividend Achievers™ Index. PBI’s revenue growth has been unimpressive and they will need to integrate recent acquisitions. Historically, PBI has maintaind a steady cash flow from recurring revenue streams, and it has used this cash flow to execute a consistent dividend policy and share buyback program.

Conclusion: PBI lost one Star in the Fair Value section, earned one Star in the Dividend Analytical Data section and lost one Star in the Dividend Income vs. MMA section for a net total of negative one Star. Since my scale bottoms out at zero, this quantitatively ranks PBI as a 0 Star-Avoid stock.

Using my D4L-PreScreen.xls model, I determined the share price would have to drop to $28.11 before PBI’s NPV MMA Diff. increases to the $3,000 NPV MMA Diff. that I like to see. At that price PBI would yield 4.98%.

Resetting the D4L-PreScreen.xls model and solving for the dividend growth rate needed to generate the $3,000 NPV MMA Differential I’m looking for, the calculated rate is 6.3%. This dividend growth rate is substantially abovethe 2.1% average between 2001-and 2007. PBI has a long way to go before it earns a spot in my income portfolio.

Disclaimer: Material presented here is for informational purposes only. The above quantitative stock analysis, including the Star rating, is mechanically calculated and is based on historical information. The analysis assumes the stock will perform in the future as it has in the past. This is generally never true. Before buying or selling any stock you should do your own research and reach your own conclusion. See my Disclaimer for more information.

Full Disclosure: At the time of this writing, I had no position in PBI (0.0% of my Income Portfolio) .

What are your thoughts on PBI?